Tim Cook, the chief executive of Apple Inc., came to the U.S. Senate on May 21 to advocate an overhaul of the nation's corporate tax code. Tax profits at 20 percent, Cook said, and offer no loopholes, no deductions, no complexities.
The recommendation might seem radical. It isn't. Apple might be a visionary in consumer electronics and software, but not when it comes to taxes. The best way to reform corporate taxation isn't to cut the rate but abolish it.
A wide consensus of economists and tax experts finds it to be bad policy. Nobody, so far as I could find, thought that corporate taxes were a smart or efficient way for governments to raise revenue. Economic theory provides no strong argument for special taxation of corporate income, at whatever rate.
If Apple can reinvigorate discussion of corporate tax reform, that will be quite the achievement. Economists have considered these issues in considerable depth. It is worth reviewing their conclusions before political debate begins:
Economists have debated this for 50 years, beginning with a paper by Arnold C. Harberger, which found that the burden falls entirely on the owners of capital (and not at all on workers). The issue is still debated. Alan J. Auerbach has written an accessible summary of the literature on the incidence of the tax.
Economists can't even agree about whether they disagree, according to Benjamin H. Harris of the Tax Policy Center.
One survey finds that 75 percent of economists think the tax mostly hits capital; another finds that economists on average think it’s a 60-40 split toward labor. In a way, it doesn't matter. If the tax falls on labor, that's bad because it fails to reflect ability to pay. If it falls on capital, then standard arguments against high capital taxation apply -- and they're persuasive.
How does it distort?
Taxes distort incentives, and corporate taxes especially so. Those distortions impose costs on the economy. "The domestic distortions that the corporate income tax induces are large compared with the revenues that the tax generates," the Congressional Budget Office wrote in a 2005 report. It found that for every dollar raised by corporate taxation, the cost due to distortions was between 24 and 65 cents. The harm is done through four main channels: corporate finance; corporate organization; investment in tax avoidance, and industrial structure.
Apple borrowed $17 billion to help finance $55 billion in share repurchases earlier this month, even though it had $100 billion in idle cash already. The decision makes no sense until one calculates, as Bloomberg's Peter Burrows did, that Apple saved $9.2 billion as a result. Apple would have had to bring back profits from abroad to use its own cash, and repatriated profits face tax.
These levies are severely distortive. A study in 2001 found that a cut of 1 percentage point in the repatriation tax rate increased dividends by 1 percent; the efficiency loss from the tax was estimated to be 2.5 percent of annual U.S. dividends, or about $290 billion in 2011. The corporate tax also distorts the choice between debt and equity financing, because interest payments are tax-deductible and dividends aren't. For every reduction of 10 percentage points in the tax discrepancy, it's been estimated, the fraction of all corporate assets financed by debt falls 3.5 percent. Again, the efficiency loss runs into the tens of billions of dollars. Subsidizing leverage, by the way, is also deeply problematic for corporate governance.
Companies can avoid corporate taxes by becoming "a pass-through entity" such as a partnership or an S corporation. According to a survey of the research, this has a strong influence on how companies organize. For every change of 10 percentage points in the tax rate, 7 percent of companies will switch their form. Austan Goolsbee, a former chairman of the Council of Economic Advisers under President Barack Obama, found that this distortion alone created a dead-weight loss of between 5 percent and 10 percent of the tax's revenue.
Investment in tax avoidance
Apple didn't set up an Irish shell corporation because its executives enjoy visiting the Emerald Isle. They did it because it saved them billions. For the company, it made sense -- but when businesses spend real resources to reduce their tax burden, from society's point of view every dollar is wasted. Data on tax avoidance and evasion is hard to come by, but one study suggests that the rate of underreporting for the corporate tax is 17.4 percent, implying an annual loss of $30 billion, almost all of which goes to the largest companies. A second study by accountants finds that the benefits accrue to a quarter of all companies -- the ones large enough to afford teams of tax preparers and to make use of shelters. Those in this aggressive group are able to reduce their tax rate by 10 percentage points or more.
It's a mistake to tax corporations at all. But it's in another realm of stupid to create differences in tax rates among industries and companies -- as the U.S. has done. Using data from the Tax Policy Center, for instance, I calculated that manufacturers used tax credits to cut their average tax burden by more than half -- compared with a reduction of less than 10 percent for retailers. This is indefensible. When some industries are, in effect, subsidized in this way, patterns of investment, exit and entry are all distorted. Americans are better off when the success of corporations is determined by their competitiveness rather than their tax planning.
Can we replace the revenue?
If the corporate tax were abolished, the revenue would need to be found elsewhere. The tax raised $372 billion last year. That's roughly one-tenth of all federal revenue, making corporations the third largest source after individual incomes and payrolls. It turns out this isn't all that large of a problem: the U.S. has let corporate tax revenue fall and be replaced since the 1950s, when the tax raised a third of federal revenue.
Bloomberg's editors have suggested making up the difference with, among other things, higher taxes on individuals' investment incomes. Greg Mankiw has proposed that the corporate tax be swapped with a tax on carbon polluters -- a great idea, since it replaces a highly inefficient tax with one that actually improves economic efficiency.
Do we have to cut corporate taxes?
What economists call "tax competition" makes reform a more realistic prospect than you might think. Governments already set corporate tax rates with a view to attracting international flows of capital. Rates have fallen a lot in recent years, according to Kevin Hassett, of the American Enterprise Institute, and a study in 2008 found that this trend could be explained "almost entirely" by tax competition.
Because the U.S. has such a big domestic economy, it has more power to levy corporate taxes than smaller countries. Nonetheless, the fact that it has high rates by international standards still puts the U.S. economy at a disadvantage. It's a self-interested argument for American business to advance, but that doesn't make it wrong. And the logic of tax competition only reinforces the other arguments for lowering and preferably abolishing the U.S. corporate-income tax -- a case that has solid academic backing.
Domestic Manufacturing Activities
Big fan: Starbucks Starbucks is <a href="http://www.huffingtonpost.com/2013/02/15/obama-corporate-tax-reform_n_2680880.html" target="_blank">among the companies</a> that have successfully lobbied to qualify for a tax break that rewards U.S. manufacturing. As a result, activities like roasting coffee beans count as domestic manufacturing and are eligible for tax breaks.
Excess Stock Options
Big fan: Facebook About 280 Fortune 500 companies have taken home a total of <a href="http://www.huffingtonpost.com/2013/04/24/mcdonalds-starbucks-apple-tax-break_n_3147875.html?utm_hp_ref=business" target="_blank">$27.3 billion over the past three years</a> thanks to a tax break that allows corporations to treat executive stock awards like cash compensation -- meaning the money can be written off like a business expense -- according to a recent report from the Citizens for Tax Justice. Critics argue that this defies "common sense," given stock options aren't a cost to the company like cash compensation is. Facebook <a href="http://www.businessweek.com/articles/2013-02-15/facebook-gets-a-multi-billion-dollar-tax-break" target="_blank">used this single loophole</a> to wipe out its entire tax liability last year.
Big fan: Duke Energy Accelerated depreciation <a href="http://www.huffingtonpost.com/2013/04/15/corporate-tax-breaks-cost_n_3087972.html" target="_blank">accounted for $76 billion</a> in revenue loss in 2011, the most of any corporate tax break, according to the Government Accountability Office. The tax break allows businesses to write off the costs of ostensibly deteriorating machinery before the equipment even wears out. A Citizens for Tax Justice study <a href="http://www.reuters.com/article/2012/04/10/us-usa-tax-corporations-idUSBRE8380TJ20120410" target="_blank">found that Duke Energy</a> managed to reduce its tax liability largely by using this tax break. Duke called the study misleading.
Deferral On Overseas Profits
Big fan: Apple Fortune 500 companies, including Apple, have <a href="http://www.huffingtonpost.com/2012/12/14/fortune-500-overseas-profits_n_2301223.html" target="_blank">more than $1.6 trillion in profits</a> parked offshore, according to multiple recent studies. By keeping that money overseas, companies are able to avoid paying U.S. taxes on the profits.
Exclusion Of Interest On State And Municipal Bonds
Big fan: Goldman Sachs When companies invest in state and municipal bonds, they are <a href="http://www.thefiscaltimes.com/Articles/2011/02/09/10-Big-Corporate-Tax-Breaks.aspx#page2" target="_blank">exempt from taxes</a> on the interest they earn from those bonds. This is one corporate tax break that individuals can take advantage of as well, though it largely benefits the wealthy. As a result of the loophole, the <a href="http://www.thefiscaltimes.com/Articles/2011/02/09/10-Big-Corporate-Tax-Breaks.aspx#page2" target="_blank">government has lost $58 billion</a> over the past five years, according to the Fiscal Times. Companies including Goldman Sachs have benefitted from the exemption by using the tax exempt bonds to build new offices, <a href="http://www.nytimes.com/2013/03/05/business/qualified-private-activity-bonds-come-under-new-scrutiny.html?pagewanted=all" target="_blank">according to The New York Times</a>.
Fossil Fuel Subsidies
Big fan: Continental Resources Oil and gas companies currently benefit from tax breaks that they say encourage innovation by subsidizing hunts for oil and gas that may not turn out to be fruitful. The result: Continental Resources <a href="http://www.huffingtonpost.com/2012/09/14/harold-hamm-tax-break_n_1884327.html" target="_blank">paid an effective tax rate of 2.2 percent</a> over the past 5 years. Chevron and Exxon Mobil paid tax rates at 4 percent and 2 percent, respectively. Pictured is Harold Hamm, Continental Resources' CEO.
Big fan: Google Those famous free lunches in the Google cafeteria are <a href="http://online.wsj.com/article/SB10001424127887324050304578408461566171752.html" target="_hplink">currently offered tax-free</a>, according to the Wall Street Journal. Right now, the lunches aren't treated as taxable compensation, so employees are benefitting from the free food, but don't have to pay taxes on it.
Corporate Jet Owners Tax Break
Big fan: The aviation industry, <a href="http://www.huffingtonpost.com/2013/03/20/obama-corporate-jet_n_2912781.html" target="_hplink">specifically companies like Cessna</a>, Beechcraft and Learjet This tax break, which allows companies to deduct the cost of a corporate jet from their tax bill like they would any other business expense, got its moment in the spotlight when President Barack Obama <a href="http://www.huffingtonpost.com/2013/03/20/obama-corporate-jet_n_2912781.html" target="_blank">highlighted it as an unfair perk for the rich</a>. The president's 2011 budget<a href="http://www.huffingtonpost.com/2011/09/19/obama-corporate-jet-taxes_n_970384.html" target="_blank"> pushed for an increase in the per-flight fee</a> for private jets from $60 to $100, yet the break remains in effect today. Companies that make jets, like Cessna, Beechcraft and Learjet, benefit from the subsidy as it supports the aviation industry, <a href="http://www.huffingtonpost.com/2013/03/20/obama-corporate-jet_n_2912781.html" target="_blank">according to proponents of the subsidy</a>.